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Boardroom Focus: Bringing Insight to Oversight

How to use the board of directors to build a more resilient enterprise.

Fortnightly Magazine - June 2005

its thinking and gains for itself the understanding needed to sift the important from the unimportant in the information made available to it.

Risk Appreciation

Any strategy involves risk. What distinguishes the good strategy is not absence of risk but the clarity with which the risks are identified and the availability of measures to mitigate those risks. It is not the board's duty to eliminate risk, but rather to ensure that it is appreciated and anticipated by management.

In recent years energy companies have become experts in the technical refinements of risk management. They have adopted sophisticated metrics to track capital exposure, return on capital exposed, and value at risk. Yet while these techniques have been valuable in their own realms, they also have been confined. Their application for the most part has been bound within the visibly high-risk box of trading. Meanwhile the industry's really catastrophic meltdowns have come from risk at a higher level, existing entirely outside that box: a high-risk market structure, for instance, in the case of the California utilities, or a high-risk web of financial structures and financial commitments at Enron. Both types of meltdown, ironically, occurred in companies that were celebrated for their risk-management sophistication and proficiency.

As the events of the past few years amply demonstrate, risks at the strategic level ( i.e., material risks to the accomplishment of the company's strategic objectives) arise from many sources other than the trading floor: regulatory policy, technology commercialization, fuel prices, capacity swings, credit ratings, natural disasters, and so on. Those utilities that believe avoiding or exiting trading is a low-risk strategy are likely to be disappointed. For the most part they're simply withdrawn from a risk zone that is intimidating because exotic to one that is comfortable because familiar. The risks in that comfort zone may be different, and the company may feel accustomed to them, but they are no less real. Risks remain, and the board needs to understand them.

Fortunately, risks at the strategic level, unlike risks on the trading floor, can be framed in an intuitively accessible way. Once the board understands the logic and the factual premises that link the company's strategy to its objectives, it is in position to appreciate the impact of variations from those premises that may arise as events unfold, to consider the likelihood of such variations, and to assess the adequacy of management's fall-back plans if those variations occur.

This is why executives and board members must treat risk and strategy as two sides of the same coin. Strategy can be assessed only when risk is understood. Risk can be assessed only when strategy is understood. This point seems self-evident, yet governance practice rarely acknowledges it. Typically when the board reviews strategy, that review occurs at a general level. Management pitches the strategy in the most appealing way possible, rarely taking it apart to expose the (inevitable) underlying uncertainties. To the extent alternatives are presented, they often take the form of one alternative that is stupid, or another that is formally recommended. Moreover, these strategy presentations typically